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Choosing Your Annual Withdrawal Rate

After years of building financial assets, the time will come when you begin drawing on them to pay expenses during retirement. Before that major turning point arrives, be sure to give careful thought to how much money you will take out of your personal savings and investment portfolio each year. The rate at which you withdraw money from your assets is one of the most important factors affecting how long they will last. In other words, it's not only the amount of money you have saved, but how quickly you spend it that will help determine whether you can still live comfortably in your later years.

What to Consider

A number of factors will influence your choice of an appropriate withdrawal rate. These include your age and health, the potential impact of inflation on your assets and cost of living, and the variability of investment returns you earn on your savings. If you plan to leave a legacy to your heirs, you should allow for this in determining how much to withdraw from your portfolio as well.

As you think about what your withdrawal rate should be, begin by considering your age and health. Although you can't predict for certain how long you will live, you can make an estimate. However, it may not be wise to base your estimate on average life expectancy for your age and sex. Particularly if you are healthy, you should take into account your risk of living longer than a life expectancy table would indicate. While average life expectancy has risen steadily in the United States, reaching 78.2 years for a child born in 2007, there's a 50% probability now that a healthy 65-year-old man could live to age 85 and a 65-year-old woman in good health could live to age 88. Moreover, there's a 25% probability of the man living to age 92 and the woman to age 94. If they retired at age 65, they could be withdrawing from their assets for 30 or more years.1

Dealing With Economic Realities

Once you've estimated your likely longevity, think next about inflation, which is the tendency for prices to increase over time. Keep in mind that inflation not only raises the future cost of goods and services, but also affects the value of assets set aside to meet those costs. The real return on assets is their value after subtracting for inflation. To account for the impact of inflation, include an annual percentage increase for inflation in your retirement income plan.

How much inflation should you plan for? Although the rate varies from year to year, U.S. consumer price inflation has averaged about 4% over the past 50 years.2 Therefore, for long-term planning purposes, you might choose to assume that inflation would average 4% a year. However, if inflation flares up above the level you assume after you have retired, you may need to adjust your withdrawal rate to reflect the impact of higher inflation on both your expenses and investment returns. Keep in mind as well that you should periodically assess the potential of your investment portfolio to generate income that will at least keep pace with inflation.

Fluctuating Returns

When considering how much your investments may return over the course of your retirement, you might think you could base them on historical averages, as you may have done when projecting how many years you needed to reach your retirement savings goal. But once you start taking income from your portfolio, you no longer have the luxury of time to recover from possible market losses.

Just imagine how long it would take to restore the value of a portfolio if it suffered a large loss due to a market downturn. For example, if a portfolio worth $250,000 incurred successive annual declines of 12% and 7%, its value would be reduced to $204,600, and it would require a gain of nearly 23% the next year to restore its value to $250,000.3 When a retiree's need for annual withdrawals is added to poor performance, the result can be a much earlier depletion of assets than would have occurred if portfolio returns had increased steadily.

Coming to a Decision

Although past performance cannot predict future results, the ups and downs registered by the financial markets and inflation can be instructive when choosing an annual withdrawal rate. To provide an idea of how much might be withdrawn annually from a balanced portfolio so that it would be likely to last 30 years or more, Standard & Poor's looked back at the actual record for stocks, bonds, and inflation and analyzed all possible 30-calendar-year holding periods since 1926. It determined that the average sustainable withdrawal rate for a portfolio composed of 60% U.S. stocks and 40% investment-grade bonds was about 6.0% per year when adjusted for inflation (see chart).4



How Long Will the Money Last?
The ups and downs of the financial markets and inflation largely determine the income-producing potential of an investment portfolio. This chart depicts the average rate of annual withdrawals that a hypothetical portfolio of U.S. stocks and Treasury bonds was able to sustain during a series of 30-year holding periods since 1926. The average sustainable rate for all 30-year rolling periods from 1926 to 2012 was 6.0% when adjusted for actual consumer price inflation.
graph image
Source: Standard & Poor's. This example assumes a portfolio composed of 60% stocks, represented by the S&P 500 index, and 40% bonds, represented by a composite of returns on long-term government bonds, derived from yields published by the Federal Reserve, and the Barclays Long-Term U.S. Government Bond index. Annual withdrawals are adjusted for inflation based on actual historical changes to the Consumer Price Index. Investors cannot invest directly in any index. This illustration does not take into account any transaction costs or taxes and is not representative of any particular investment or security. Past performance is not a guarantee future results.(CS000225)

In view of the variability of inflation and investment returns, as well as the risk of living beyond your average life expectancy, you may want to err on the side of caution and choose an annual withdrawal rate somewhat below 5.9%. The goal, after all, is to crack your nest egg in such a way that it will provide a reliable stream of income for as long as you live. That may mean taking out less in the early years of retirement with the hope of having sufficient income for your later years.

This example is not intended as investment advice. Be sure to consult a financial advisor about choosing a withdrawal rate and how these issues and examples relate to your own financial situation.

Points to Remember

  1. The rate of annual withdrawals from personal savings and investments helps determine how long those assets will last and thus whether you will have sufficient income for your later years.
  2. To determine a sustainable annual withdrawal rate, consider your age and health and how future variations in the rate of inflation and investment returns may affect your retirement assets. A desire to leave a portion of your assets to heirs may also factor into the withdrawal rate decision.
  3. Assuming average life expectancy may not be prudent in view of the probabilities for living longer than an average life span. Similarly, it may be misleading to assume that investment returns and rates of inflation will closely mirror their historical averages.
  4. A jump in inflation or investment losses due to market downturns can have a significant impact on the income generated by retirement assets. As a result, it may be wise to choose a conservative withdrawal rate especially in the early years of retirement.


1Source: Centers for Disease Control, National Center for Health Statistics, 2011 (based on preliminary 2009 data, latest available).

2Source: Bureau of Labor Statistics, December 31, 2012.

3Example is hypothetical and for illustrative purposes only.

4The example was derived from the 57 30-calendar-year holding periods from 1926 to 2012. It assumes a portfolio composed of 60% stocks, represented by the S&P 500, and 40% bonds, represented by a composite of the total returns of long-term U.S. government bonds, calculated from yields published by the Federal Reserve, the Barclays Long-Term Government Bond index, rebalanced annually. The initial withdrawal is set as a percentage of the first-year value and adjusted thereafter for inflation based on actual historical changes in the Consumer Price Index. Investors cannot invest directly in any index. This illustration does not take into account any transaction costs or taxes and is not representative of any particular investment or security. Past performance does not guarantee future results.



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